Paying for Space in a Gross Commercial Lease

If you’re sure that you’ll be paying a fixed rate for the space and that you’ll owe the landlord no additional charges, the rent clause in the landlord’s lease ought to be fairly simple. The trickiest issue is how the landlord has measured the space. If it’s been measured from the exterior of outside walls with no deduction for the thickness of interior walls, you’re paying for a lot of plaster. It’s prudent to measure the space yourself to confirm the landlord’s figure, whatever the method that’s been used. Clearly, if there’s a significant difference you will want to raise the issue during negotiations.

There are other important issues to bear in mind if you have a gross lease. Things may not be as simple as you think. Your landlord might:

provide for a rent hike during the lease term, or

make you responsible for certain operating costs in addition to the rent.

Let’s look at these possibilities.

Rent Escalation

In anticipation of inflation, some landlords want the rent to increase year to year according to some formula. Sometimes the increase is flat and clear, such as an increase of $0.20 per square foot per year. Another way landlords provide for a yearly rent increase is by tying it to the Consumer Price Index (CPI) for your region. With this approach, the percentage of CPI growth is applied to the base rent—if the CPI goes up 5%, your rent goes up 5% or some portion thereof. A rent increase based on the CPI, however, can turn out to be very expensive for you, for there’s no guarantee that the value of the building will increase at the same rate as the CPI. And if
the rate of inflation is high, the CPI may be way ahead of your ability to make a profit in your particular business.

Another drawback to using the CPI as the rent escalator is that you’ll never know how high the rent can go unless there is a limit or “cap.” In fact, a CPI-based rent escalator should have both a ceiling and a floor (known as a “collar”). Why? Let’s look at it from your point of view. Suppose you want to take out a loan to cover the expense of a new computer system for your office or a piece of equipment for your shop. Your
lender will want to know what your expenses and income are likely to be during the life of the loan (that will give the lender a good idea about whether you’ll be able to repay it). Now, if there’s no cap on your
rent, the lender may worry that your rent could become so expensive that you wouldn’t be able to meet your repayment obligations. And if the lender is worried enough, he may deny the loan.

For this reason, you should negotiate for a ceiling to the rent—no higher than you could comfortably afford. Point out to the landlord that the ceiling may never be reached. It will mollify your potential lenders, which benefits the landlord as well (you can reasonably argue that a thriving tenant with sufficient capital is one who
pays the rent on time). Don’t be surprised if the landlord counters with a demand that you agree to a “floor,” which will guarantee a minimum rent in case the CPI decreases. Echoing your reasoning, the landlord may argue that without a minimum rent, lenders may worry that the landlord too may not have the income to repay a loan. You may have to settle for a compromise: You get a cap and the landlord gets a floor, such as an agreement that a decrease in the CPI won’t affect the rent until a specified amount of time has passed.

Example

Landlord Spiffy Properties LLC and tenant Protobiz Inc. agree that rent increases will be tied to the annual changes in the CPI for their metropolitan area. They also agree that Spiffy will get at least a 2% increase each year and that Protobiz won’t have to pay more than a 4% increase. One year the CPI increase is 5%. Protobiz has to pay for only a 4% increase—the cap agreed to in the lease.

Gross Lease With Stops

Many landlords are reluctant to offer a pure gross lease—one where, even with a rent escalator, the entire risk of rising operating costs is on the landlord. For example, if the landlord heats the building and the cost of
heating oil goes sky high, the tenant will continue to pay the same rent, while the landlord’s profit is eaten away by oil bills. To build in some protection, your landlord might offer a gross lease “with stops,” which means that when specified operating costs reach a certain level, you begin to pitch in. Typically, the landlord will name a particular year, called the “base year,” against which to measure the rise in costs (often, the base year is the first year of your lease). It’s a bit like turning a gross lease into a net lease if certain conditions—
heightened operating expenses—are met.

If your landlord proposes a gross lease with stops, understand that your rental obligations will no longer be a simple “X square feet times $Y per square foot” every month. As soon as the stop point—an agreed-upon operating cost—is reached, you’ll be responsible for a portion of specified expenses—insurance premiums, tax bills, or maintenance costs. During negotiations concerning a gross lease with stops, consider the following points:

What operating costs will be considered? Obviously, the landlord will want to include as many operating
expenses as he can, from taxes, insurance, and common area maintenance to building security, capital expenses (such as a new roof), and even legal costs and expenses associated with leasing other parts of the building. Do
your best to keep the list short and, above all, clear.

Where is the “stop” point? The landlord will want you to begin contributing to operating costs as soon as they begin to uncomfortably eat into his profit margin. If the landlord is already making a handsome return on the property (which will happen if the market is tight), he has less need to demand a low stop point—but by the
same token, you have less bargaining clout to demand a higher point.

How are added costs allocated? If you’re in a multitenant situation, will all tenants contribute to the added expense? How will the charges be allocated—according to the amount of space you rent, or according to
your use of the particular service? For example, if the building-wide heating bills go way up but only one tenant
runs the furnace every weekend, will you be expected to pay the added costs in equal measures, even if you’re never open for business on the weekends?

Will the stop level remain the same during the life of the lease? The idea of a stop point is to relieve the landlord from paying for some—but not all— increased operating expenses. As the years pass (and the cost of running the property rises), you’ll pay for an increasingly large portion of the landlord’s costs unless you can negotiate for a periodic upward adjustment of the stop point. Your ability to press for this will improve if the landlord has built in some form of rent escalation, explained above. Why? Because you can argue that if
it’s reasonable to increase the rent based on an assumption that operating costs will rise, it’s also reasonable
to raise the point at which you begin to pay for those costs. To do on without the other allows the landlord,
but not you, to adjust expenses based on inflationary increases.

"Grossing Up" the Base Year in Multitenant Buildings

If your gross lease in a multitenant building includes a provision allowing the landlord to begin charging you when operating costs rise above a certain level, the landlord will probably include a “gross-up” clause in the
lease if the building is not fully occupied during your base year. This clause ensures that you pay your fair share of any increased costs. Here’s why this clause is necessary, and how it works.

Suppose you rent one entire floor of a ten-story building, but the rest of the building is vacant. The lease provides that when electricity usage rises above the cost in the first year, you begin to pay 10% of the excess.
In the first year, the bill is $100,000, so that becomes the base year. Now, assume that in the second year, all floors are occupied and everyone uses the same amount of electricity, so that the bill for the second year is $1,000,000. Since that’s $900,000 above the base year amount, you’ll begin paying 10% of $900,000, or $9,000—even
though your usage hasn’t changed and you should be paying nothing.

The way to remedy this problem is to figure
the base year figure as if the building
were fully leased, with everyone using the
same amount of electricity. To “gross up”
the base year figure, then, you’d ask the
landlord to make the base-year electricity
number $1,000,000 (ten stories of ten tenants,
each using $100,000 worth of electricity).
Under this scenario, in the second year
you’ll still pay nothing since the buildingwide
bill is not over $1,000,000.

Grossing-up is appropriate only for variable
costs, such as maintenance, utilities,
cleaning, and some repairs. Fixed costs,
such as the cost of insurance and property
taxes, which don’t vary depending on building
occupancy, don’t require grossing-up.